Wall Street’s Bonus System Major Catalyst for Financial Crisis

By: Money_Morning

Shah Gilani writes: In a report released last week, New York State Comptroller Thomas P. DiNapoli estimated that the securities industry granted its employees $18.4 billion in bonuses – a revelation that President Barack Obama characterized as “shameful.”

Not surprisingly, the audacity of The Street's greed is far more shameful than people realize, because the total payout was actually much higher than the report found.

What wasn't widely reported is that the $18.4 billion was only the cash portion of the bonus payout and only accounted for the money paid to securities-industry employees who worked in New York City. In other words, bonuses paid to employees working outside the city weren't included. The Comptroller's estimates also didn't include stock options that have not been exercised, but that could easily increase the value of the bonus-related compensation by as much as 25% to 100%.

Wall Street's greed precipitated the banking-and-credit crises, leaving taxpayers to foot the bill.  Now those same taxpayers are being asked to finance Wall Street's bonus payouts, which were actually a proximate cause of the crisis. They fueled a culture of greed and avarice, and created incentives for actions that led to the near-collapse of the U.S. banking system.

The Street's greed, deceit and indifference are not only shameful; each is also a travesty of a mockery of a sham.

Understanding the compensation equation requires a look at more than just the numbers.

Backgrounder on Bonuses

Proxy season is fast-approaching: It's the time of year when U.S. public companies – in advance of their annual stockholders' meetings – send out the proxy statements that detail such items as shareholder resolutions and top-executive compensation. The American business press typically uses that as an opportunity to declare open season on executive compensation, running long stories that detail the seemingly huge payouts in cash, bonuses and grants of both restricted stock and stock options.

This year, however, due to the ongoing financial crisis, the executive-pay controversy has been elevated to an even-higher higher level. Companies that accepted government bailout money have still paid out big bonuses, attracting the ire of federal lawmakers and the new U.S. president alike.

Just yesterday (Wednesday), in fact, President Obama announced a salary cap of $500,000 for top executives at companies that receive large amounts of bailout money, calling the step an expression of both fairness and “basic common sense.” [For a detailed report on this executive-payout salary cap posted elsewhere in today's issue of Money Morning , please click here ].

For the past decade, the New York State Comptroller's office has released estimates of bonuses paid to New York City-based securities industry employees. The $18.4 billion paid out last year represents a 44% decline from the $32.9 billion dispersed in 2007.

However, the decline isn't as steep as Wall Street would have us believe. First, since New York firms last year cut their payrolls by about 19,200 people, or roughly 10.2%, from the 2007 level of 187,800, the average 2008 bonus of $112,000 was dispersed over fewer employees, meaning the payouts resulted in an actual drop of only 36 %. The average cash bonus in 2007 was $175,186.

These cash bonus figures are averaged. Not everyone gets a bonus and some folks get very large bonuses. A clerk making $35,000 a year is not going to get a $112,000 bonus; however, a trader making a salary of $150,000 might get a bonus of $2 million.

It's important to remember, too, that while all employees are paid salaries, bonuses make up the bulk of compensation packages for bankers, traders, brokers and managers.

Top-employee salaries typically run between $100,000 and $750,000, but generally fall into the low-six-figure column. At the end of last year, the top executives of Goldman Sachs Group Inc. ( GS ) decided to forgo any cash, stock or options bonus compensation for 2008 , stating that it “was the right thing to do.”

Goldman's top executives had to make do with their $600,000 salaries. As for the rest of the firm's employees, it has been reported that they will have to share a paltry 2008 bonus pool that a Goldman spokesman said could total only $2.6 billion. But not to worry: The firm likely will say that none of the $25 billion of Troubled Assets Relief Program (TARP) money it received courtesy of American taxpayers will go for bonuses. Perhaps some Wall Street accountants can explain that to me.

While forgoing 2008 bonus compensation after receiving only a $600,000 salary may seem noble, no one is shedding a tear for the Goldman executives. In 2007, Chief Executive Officer Lloyd C. Blankfein took in $68.5 million; co-presidents Jon Winkelried and Gary D. Cohn each made $67.5 million; and David A. Viniar , the firm's chief financial officer, made $57.5 million.

A Move to Regulate?

While President Obama called the $18.4 billion bonus pool “shameful,” U.S. Sen. Claire McCaskill , D-Miss., was more pointed, stating that “they [just] don't get it. These people are idiots.”

To make her point, McCaskill cited a report (also carried by Money Morning ) stating that executives at 116 banks that got government bailout funds were paid an average of $2.6 million in bonuses . She condemned Citigroup Inc. ( C ) last week for even considering taking delivery of a $50 million luxury corporate jet after having received a direct government investment of $45 billion, as well as an additional $300 billion in government insurance against losses on its toxic balance sheet. Citigroup demurred, and cancelled delivery of the jet, because of the direct pressure from the U.S. Treasury Department.

McCaskill is not just vocalizing her anger; she has sponsored a bill called the Cap Executive Officer Pay Act . Her bill proposes that any company taking any bailout money from taxpayers limit compensation, for anyone at the recipient firm, to $400,000, which as it turns out is $100,000 less than President Obama is willing to grant executives. McCaskill said she picked $400,000 because that's the salary paid to the U.S. president, and incidentally is also eight times the median U.S. household income – and which, by the way, may not seem too shabby, unless you're Goldman's Blankfein, who made more than that every two days back in 2007.

Sen. McCaskill didn't want to take away the punchbowl entirely, however; she suggested that once taxpayers receive what a company owes them, the firm is free to pay its executives whatever they want.

The Treasury's aforementioned TARP initiative requires that senior-executive compensation be subject to “clawback” provisions in the event compensation was based on inaccurate information. But for all the executives who artfully escaped with fat severances and golden parachute deals after bailing out or being pushed out of the companies they helped wreck, there's no such provision.

Perhaps there should be.

Taxpayers as well as shareholders should be able to claw back compensation from the likes of former Merrill Lynch & Co. Inc. CEO E. Stanley “Stan” O'Neal, who retired after announcing losses of $8 billion (an amount that ballooned to more than $27 billion, by the end of last year), and took a pay deal worth more than $161 million.

Then there's Citigroup boss Chuck Prince, who tiptoed off with a $38 million “bonus” after announcing billions in losses and steering the bank to the brink of insolvency.

And of course there's Martin Sullivan, the former CEO of insurance giant American International Group Inc. ( AIG ), which needed $85 billion in cash infusions and another $45 billion in backstopping by U.S. taxpayers . Sullivan, who made $39.6 million in his last three years at the firm's helm, ambled away in June with a severance package of $47 million, regulatory filings state. Sullivan got a $15 million severance, and a $4 million bonus for the portion of the year he actually worked. According to the filings, he also got to keep already-outstanding stock and long-term cash awards worth about $28 million.

In the final analysis, the fundamental question that needs to be addressed is a straightforward: Are Wall Street executives worth what they are paid, given the risks they take with money that actually belongs to shareholders (and, now, the U.S. taxpayer)?

The short answer – and I say this as a formerly well paid Wall Street executive – is   “no.” The prevailing school of thought, as espoused by those who earn such outsized compensation packages, those who are paid to do the bidding of the well-heeled and greedy, and those who aspire to the mantle of “Master of the Universe,” is: “We want the smartest people running these firms and in order to get them you have to compensate them or they will go elsewhere.”

That is the biggest sales job on all of Wall Street. No one is that smart.

There is not any value added by the majority of highly paid Wall Street bankers and traders to the economy at large. The discernable value they add is actually the value of their compensation as it becomes an element of gross domestic product (GDP). The same money would better serve the economy and GDP if a large portion of it was channeled back into shareholder value, dividends or simply resided as accumulated capital on the balance sheets of banks that would have cheaper better capital to make lower cost loans.

Now, that's an idea whose time has come.

America should always be diligent about shepherding free markets, domestically and internationally, and compensation should not be regulated by any government. There are, however, limits that need to be applied to compensation if public companies are allowed to leverage their shareholders' balance sheets and create the systemic risk that threatens us all. There were no regulators shepherding the system, which is a travesty. There were no shareholder advocates taking down greedy and profligate boards of directors, which is a mockery. And, if inordinate greed continues to undermine free markets and our capitalist system, then everything Wall Street stands for will be a sham.

[ Editor's Note : As the controversy over executive compensation on Wall Street underscores, the damage wrought by the ongoing financial crisis is both widespread and deep. After all, why else would the federal government push to limit how much the top “rainmakers” of a Wall Street firm earn each year? Clearly, it will take time to make the needed changes, meaning that uncertainty will remain the watchword for years to come. And that means investment profits will be tough to come by.

But what if you knew – ahead of time – what marketplace changes to expect? Then you'd be in the driver's seat - right? You'd know what to anticipate, could craft a profit strategy designed to specifically capitalize on those market shifts … and could then just sit back, watching as the profits roll in from the very marketplace events you predicted.

To make this scenario a profitable reality, however, you need an experienced navigator to guide you. R. Shah Gilani - a retired hedge fund manager and a nationally known expert on the U.S. credit crisis – is just that guide. Gilani has identified five new financial crisis "aftershocks" that he says will create substantial profit opportunities for investors who know just what these aftershocks are, and how to play them. In the Trigger Event Strategist , Gilani uses these “trigger events," as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, check out our latest report . Also, check out Gilani's first-person sidebar on executive compensation, located elsewhere in today's issue of Money Morning . Just click here to access that other story. ]

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